CDS : Scarier than “subprime”

CDS stands for “credit default swaps” and last Sunday, CBS 60 Minutes aired a great piece on the subject. Basically, these derivative products are a form of legalized gambling that allows to wager on financial outcomes without ever having to actually buy the stocks and bonds or mortgages. The problems started showing up with the collapse of the U.S. housing market and have been magnified worldwide by what Warren Buffet has called "financial weapons of mass destruction." This was just legal gambling with absolutely no regulatory controls. CDS were totally unregulated and big banks and investment houses that sold them didn't have to set aside any money to cover their potential losses and pay off their bets. As a practical example, if those debt instruments defaulted and were worth 8 cents on the dollar, you'd make 92 cents on each dollar of the mortgages - the same money you'd collect if you were an actual holder of the debt who'd bought the swap as insurance. Some folks and hedge fund managers were able to amass billions of dollars that way! As the market began to seize up and as the underlying obligations began to perform poorly, everybody wanted to get paid on those credit default swaps but there was no money set aside behind the commitments. And that's to a large extent what happened to Bear Sterns, Lehman Brothers, and AIG. This ability to buy insurance on things that you had no insurable interest in, transformed this market into a huge casino. These CDS would have been illegal during most of the 20th century, but eight years ago, a newly republican dominated congress gave Wall Street that exemption and it has turned out to be a very bad idea. The Commodities Future Modernization Act of 1999 was sponsored by Gramm (now vice chairman of UBS,) Leach and Blibey; it passed the very last day of that 106th lame duck congress, as lawmakers couldn't wait to go home for the Holidays, prohibiting any regulations of derivatives and gutting the Glass-Stegal Act of 1933 that had set up guidelines protecting banks until the most recent collapse. The Act, blessed by Greenspan was signed into law by Clinton. Since that time, the CDS market has been growing like crazy. It’s currently over $62 Trillion (more than the planet’s GDP,) up from under $1 Trillion a decade ago. So if you fully appreciate the extent of that mess, you’ll have to agree that some stringent regulations are sorely needed; furthermore, I certainly won’t vote for my two senators that approved the 1999 Act…